Neglected Risk: Evidence from Structured Product Counterparty Exposure

We show that initial offering prices of simple structured products do not reflect issuer credit risk before the Lehman default. After this event, credit risk is no longer neglected. Issuers then compensate general and even product-specific counterparty exposure. We find that investor attention toward issuer credit risk is a critical determinant of the occurrence of neglected risk. Additionally, banks have a propensity to construct products with larger counterparty exposure. Overall, our results shed light on whether and under which conditions financial engineering generates neglected risk in the economy.